Учебно-методический комплекс дисциплины «иностранный язык (профессиональный)»

Your Price “Business owner, if your partner had died yesterday, do you think the heirs would sell their interest to you at a price you would consider fair? (Wait for a response.) How would you go about setting a price that both you and the heirs would consider fair?” The general partners conduct the day-to-day business for the entire partnership and have unlimited liability for the firm’s obligations. Most limited partnerships deal in investment ventures such as oil and gas drilling, cattle breeding, and real estate. Legal Facts Concerning Limited Partnerships. The purpose of the limited partnership is to enable a person who has money to enter into partnership with others, without being exposed to the unlimited liabilities of a general partner. If the business fails, the limited partner can lose no more than the capital invested in the firm. The limited partner cannot be active in the management of the firm. Usually the limited partner receives a specified share of the profits. The partnership interest of a limited partner may be reached (attached) by any of his or her creditors. Upon dissolution of the partnership, the limited partner’s share has priority over funds due the general partners, but is subordinate to claims of the firm’s creditors. Upon death, the limited partner’s personal representative is entitled to the deceased’s portion of assets and deferred profits in order to settle the estate. Death of limited partner does not dissolve the partnership. However, the death of a general partner can end the business unless the partnership agreement stipulates otherwise. If a limited partnership develops too many characteristics of a corporation—even though it calls itself a partnership—it will be taxed as a corporation. Four major corporation characteristics are considered in determining whether or not a limited partnership will be classified by the IRS as a corporation for tax purposes. If the limited partnership has more than two of the following characteristics, it probably will be taxed as a corporation. Freely transferable ownership interests. Continuing of life. Participation of limited partners in management of the partnership. Limited liability of the limited partners for debts of the partnership. There are many gray areas concerning what constitutes each of these four characteristics. Thus, the limited partnership agreement must be carefully drawn—and followed—to avoid corporate tax status. Family Limited Partnership. Family limited partnership is a version of the limited partnership, the family limited partnership (FLP) is sometimes used in estate planning, especially when there is a family business interest. In a family limited partnership, a property-owning family member transfers property such as real estate and stocks to the partnership, receiving partnership units in exchange. Younger generations receive limited partnership units while the senior, donor member(s) receive general partnership units, maintaining control of the assets. Ultimately, the majority of the ownership interest is transferred to the limited partner, with the general partner retaining only a minimal number of units but retaining, as the general partner, management and responsibility for the assets. A family limited partnership is a legal agreement that allows business owners and their children to address several business-succession and estate planning needs all at once. It works like this: Mother and father create a limited partnership in which mother and father are the general partners, and their children (and/or grandchildren) are the limited partners. Mother and father transfer property to this partnership. The property may be stocks, bonds, cash, the family farm or stock in the family C corporation. Mother and father no longer own these assets. In exchange for their contributions of property to the limited partnership, they receive units of ownership in the family limited partnership. Over time, mother and father will give ownership of most of the partnership to the children, following a “planned gifting” program. But they will not give up control over the partnership until both have died. Understanding what happens as a result of setting up such a limited family partnership requires an understanding of some tax laws that are beyond the scope of this course. In essence, however, the primary benefit is its ability to reduce the size of mother and father’s taxable estate, thereby reducing the amount of federal estate tax at death. This benefit comes as a result of the planned gifting program and is based on tax laws allowing less-than-asset value to be placed on the C-corporation stock of the business held by the children. The reduced value is based the fact that non-marketable stock and minority interest stock are allowed to be discounted for IRS purposes. This discounted price results in lower gift tax at time of giving and lower estate tax at death. The limited partnership arrangement lets mother and father, as the general partners, control the business despite the fact that they may own less than 1 percent interest in the limited partnership. There is a lot more to know about family limited partnerships, but this basic information provides enough of a foundation for you to be familiar with the concept and to ask your family-owned C-corporation owners if they have examined the concept with their legal advisers and accountants. Professional partnership Professional Partnership is another way of differentiating partnerships is to divide them into commercial (business) partnerships and professional (personal service) partnerships. Typical professional or personal service partnerships are legal, medical, engineering, architectural, accounting, dental, advertising, consulting firms, realtors, and brokers. Though most of the characteristics of professional partnerships and commercial partnerships are the same, professional partnerships do have a few distinctive characteristics. Partners often meet the challenge of work a little better and to make more money in a partnership than working alone. For example, a survey by the National Income Division of the Office of Business Economics shows that lawyers operating in partnerships earn more on average than lawyers operating alone. Surveys among other professional groups would undoubtedly indicate the same situation. Because this is true, an obligation is created. The partners owe each other some measure of responsibility for their enhanced positions. When one of the partners dies, the survivors are keenly aware of this debt. Your opportunity is to help partners realize this obligation before one of them dies, while there is still time to use the best solution. The Difference between Partnerships. How does a professional partnership differ from a commercial partnership? An important difference lies in the character of assets. Most commercial partnerships are capital intensive. That is, a substantial part of the value of the firm is represented by its physical assets such as real estate, machinery, fixtures, equipment, materials, supplies, inventory, and so forth. In short, tangible assets are an essential part of the business. These capital assets constitute a large part of the value of each partner’s interest in the business, directly or indirectly. The more capital intensive, the more likely there is debt. With professional partnerships, the situation is quite different. They are usually not capital intensive. The real value of the typical personal service partnership lies in the training, knowledge, skill, experience, character, and reputation of the individual members of the firm. As consequence, the firm’s income is derived almost entirely from the personal services rendered by the partners. Capital, in the form of tangible assets, is generally incidental to the operation of most professional partnerships. Little, if any, income results from these physical or tangible assets. Similarly, commercial partnerships frequently allow a good-sized portion of their profits to remain in the business. Partners in personal service firms are far more likely to withdraw the bulk of the earnings. The result is often minimal working capital within the professional partnership. A Key Difference for Professional Partnerships. There is one additional way in which commercial and professional partnerships differ. Partners must be qualified members of a given profession. A deceased partner’s heirs cannot come into the business as partners unless they too are qualified professionals in the same field. Under the Uniform Partnership Act, professional partnerships face the same threat of liquidation after a partner’s death as do commercial partnerships. The need for a solution to the problem is just as urgent and vital with professional partnerships as with commercial partnerships. Activities 1. If your friend was making a success of a sole proprietor business, and was considering taking on a partner, what impartial advice would you give that friend? 1. Speak about background on a partnership. 2. Give distinguishing characteristic of a partnership. 3. Name all advantages of a partnership. 4. Name all disadvantages of a partnership. 5. Compare the nature and aims of a private sector organization with those of a public sector organization. Theme IV. Forms of Business Organizations (Corporations) Lecture 4. Learning Objectives An understanding of the material in this lecture should enable the student to 1. Describe 10 Different Forms of Business Organization, and Identify. 2. Dive the Distinguishing Characteristics of Corporations. 3. Know Chief Characteristics of Corporations. 4. Describe C corporation 5. Describe S corporation 6. Describe Corporate Management 7. Describe Stockholders of Corporations. 8. Describe Board of a Corporation 9. Describe Corporation Officers. 10. Describe Capital Stock. 11. Describe the Major Advantages and Disadvantages of Corporations. Corporations A corporation has been defined by Ames and Ames in their authoritative work. Private Corporations as "a body, created by law, composed of individuals united under a common name, the members of which succeed each other, so that the body continues the same notwithstanding the change of individuals who compose it, and is, for certain purposes, considered as a natural person." From this definition, we may derive the following important facts about the corporate form: • A corporation is created by law. • A corporation is invisible and intangible. It cannot be seen, as can the buildings and machinery owned by the corporation. • A corporation is an intangible artificial being—an entity separate and independent from the owners of its capital stock. As an entity, it is viewed as an artificial person and is subject to many of the privileges and restrictions of a natural person. Corporations are divided into two classes: (1) those organized and conducted for profit and (2) not-for-profit (nonprofit) organizations, which are generally created for educational, charitable, religious, or public purposes. Nonprofits generally pay no federal income taxes. Corporations organized for profit are the only ones to be considered here. They include all corporations organized for business purposes. C corporation closely held corporation. There are a few kinds of "for profit" corporations. Most corporations are C-corporations, named after subsection C of the Internal Revenue Code. C corporations not traded on the stock market are referred to as closely held corporations. Corporations traded on the stock markets are referred to as publicly held corporations. S corporation Second are S corporations, which resemble partnerships in many ways, including some tax aspects. First - personal service corporation Second – professional corporation Third are personal-service corporations, which are primarily service oriented as opposed to product oriented. They are taxed somewhat differently than C corporations. One variety of personal service corporations is the professional corporation, operating in such services as dentistry, medicine, and accounting. Chief Characteristics of Corporations Because a corporation is a separate legal entity, certain characteristics distinguish it from the sole proprietorship and the partnership. 1. Limited liability of stockholders The corporate form of business enables persons to own part of a business and yet limit their losses (in case of failure) to the amount of their investment in the capital stock. This is true even if the assets of the corporation are not sufficient to pay its own debts. (Sometimes creditors will not extend credit to the corporation; they will insist that stockholders sign personal notes. This calls for life insurance to cover the debt, which will be discussed later.) The corporation itself is responsible for its own actions and liabilities; creditors have no claim to the personal assets of a stockholder to satisfy claims that are strictly against the corporation. 2. Continuity of existence Corporations can go on indefinitely. An owner’s death, withdrawal, mental incompetence, or bankruptcy does not in itself interrupt the corporation’s continued existence. The same is true in the event of a stockholder’s retirement or change in the corporation’s stockholders, directors, or officers. 3. Ease of transferability of interest A stockholder is an owner of part of a corporation. Ownership is evidenced by a stock certificate issued by the corporation. Unless restricted by contractual agreement, such a share of stock may be transferred from person to person simply by an endorsement on the certificate by the owner, without necessarily affecting the operations of the corporation. It can also be transferred at death through the stockholder’s will. Capital It is a common occurrence today for corporations to increase their capital stock for expansion purposes. Issuing new shares of stock for this purpose can affect the proportion of ownership among stockholders. This, in turn, can affect who controls the company. As will be discussed later, life insurance can play a key role in providing money to the corporation so that ownership and control need not change at the death of an owner. Advantages of Corporations Following are some f the corporate form of doing business. Included are contrasts with proprietorships and partnerships. Tax Status—The decision to incorporate is often influenced by the fact that owner-employees of C corporations can buy tax-deductible fringe benefits for themselves. Except for contributions to their own retirement plans, and their own group health insurance premiums, such deductions are not generally available to sole proprietors, or partners, or to most owners of S corporations. For example, if two partners buy group life insurance to cover themselves and their three other employees, they can deduct only about three-fifths of the premium for federal income tax purposes. Specifically, sole proprietors, partners and S corporations’ employees who own more than 2 percent of the outstanding stock or more than 2 percent of the voting power of the corporation can deduct the portion of the group life insurance premium that covers the three other employees, but not the portion that covers them. In general, only the cost of fringe benefits covering employees is income tax deductible by the business. If the two partners incorporated the business, they could deduct the entire premium, including the portion that covers their own lives. The law’s rationale is that corporate owners who work for their own corporation are generally considered employees of the corporation for federal income tax purposes. Partners in a partnership, sole proprietors and S corporation owners are not considered to be employees. Income Tax Levels—Many corporations manage to pay little or no income tax. This is possible if times are bad, and expenses exceed income. It is especially likely to happen if there are major items of depreciation, deductible fringe benefits, tax credits, and high salaries. Forms of Business Organization The corporate alternative minimum tax helps assure that large corporations with real economic income will pay at least a minimum amount of income tax. The alternative minimum tax is discussed at the end of this lecture. Continuity—With partnerships, even when there is a written agreement to continue, the technical fact of dissolution always occurs when a partner dies. Death of a sole proprietor has a similar result. This is not true of corporations. Legally, even the deaths of all the stockholders at once would cause no dissolution of the corporation. Obviously, legal considerations are not the sole considerations. The death of a key executive-and almost certainly the deaths of all the key executives-would shake the business to its foundations. Limited Liability—Every cent owned by a sole proprietor or partner is subject to the debts of the business. But the owner of a corporation is not liable for any corporate debts (if incurred legitimately). If the business folds, the stockholder might lose every cent invested in the business, but no more. The owner’s house and all personal property, including shares of stock in other businesses, are safe from the creditors of the failing corporation. This is a key advantage of the corporate form. Only the corporate assets themselves are subject to the claims of creditors. As a practical matter, however, the protection of limited liability is lessened in corporations which are relatively new or whose financial situations are somewhat unstable. Lenders often require one or more stockholders in these corporations to sign personal notes for business loans. Such debts become their personal responsibility if the corporation defaults. Not all corporate credit is arranged this formally, of course. Customary trade credits, for example, would usually not be a legal responsibility of the owner personally if the corporation defaults. Whether it is personal or corporate credit, there is often a need for life insurance whenever there is debt. Common reasons for incurring debt are to buy materials for inventory, loans for expansion of the business, and purchase of equipment. Life insurance on the owners or other key people is not only a prudent move; the creditor sometimes requires it. Since business loans, including normal trade credits, are continuing factors in most businesses, there is almost always a continuous level of substantial debt. This means continuous life insurance to cover the debt, either permanent insurance or renewable term insurance. Ownership Transfer of Partnerships No one can legally force an unwanted partner on a partnership. If a partner wants to withdraw from the business, he cannot simply sell his share to someone else without regard to the other partners. They can refuse or accept the offered partner. Here is a distinct difference for a stockholder. The stockholder has complete freedom legally to transfer shares to anyone. The stockholder may give away shares, will them, or sell them at any price—all without legal interference from the other owners of the corporation. They, too, enjoy this same flexibility of ownership. The corporation is blind to the identity of its owners. Disadvantages of Corporations Following are some drawbacks of the corporate form of business. Double Taxation on Dividends—Most publicly held corporations (and some that are closely held) distribute net earnings as dividends to stockholders. Net earnings are profit left after paying corporate taxes. A stockholder receiving such dividends must report them as taxable income on that year’s Form 1040. Thus, the earnings are taxed again as personal income to the stockholder. An accompanying illustration demonstrates double taxation. Ease of Transfer—The ease with which stockholders can transfer shares of stock to others is an advantage. The ease with which a stockholder’s associates can transfer his or her shares of stock to others may be a disadvantage to that shareholder. Consider a two-person corporation in which one owns 60 percent and the other 40 percent of the shares. The business runs smoothly; the owners like and respect each other. Then the majority owner, for whatever reason, transfers ownership to someone else. What happens to the minority stockholder’s position then? It certainly won’t be the same as before. The minority stockholder might even be voted out of a job. Worse yet, the minority stockholder might have little choice but to remain on the job despite an intolerable new boss. Legally, the minority stockholder is free to sell out, but who would buy into this position that the minority stockholder is trying to escape? Regulations—A price is often paid for any advantage. The owner who incorporates will pay at least the price of increased "red tape" in the form of government reports and regulations. Creation of a Corporation Most states pattern at least part of their incorporation laws after the Model Business Corporation Act. This act is a uniform code that may be adopted with or without modifications-or not at all-by the states. As a rule, firms seek incorporation in the state in which their principal activities will be conducted. However, companies doing a large interstate business usually incorporate in a state where the laws are most favorable. Some of the considerations governing the choice of the state in which to incorporate are the following: Taxes and Corporations. States or municipalities generally levy a franchise tax, a real property tax, and a personal property tax. Most states also have a corporate income tax. Some states have more favorable corporate taxes than others and thus have become favorites for those seeking corporate charters. Powers Granted to a Corporation. The powers granted to a corporation are specified in its charter, which is to a corporation what a constitution is to a state. The application for a charter is called the articles of incorporation. The charter is granted when the articles of incorporation (the application) are approved by the proper state official (usually the Secretary of State). As soon as the charter is granted, the corporation may be authorized to operate its business. The incorporators issue capital stock certificates to the original stockholders and call the first meeting of the stockholders. At this meeting, the stockholders usually elect corporate officers and a board of directors, and adopt bylaws. Corporate Management Some corporations have hundreds or thousands of stockholders. Some have only one or two. In large corporations, the vote of all stockholders on matters of daily routine would be impossible. The exercise of authority is therefore divided among three groups: stockholders, directors, and officers. The stockholders elect the board of directors. The directors formulate company policies and elect the officers. The officers execute the company policies. In most closely held corporations, the scope is much smaller. The same individuals may hold several positions. For example, closely held corporations typically have a president, a vice president, and a secretary-treasurer. These three officers might also be the directors of the closely held corporation. The same three are probably stockholders as well, quite possibly the only stockholders. Stockholders of Corporations. The stockholders are the people who own the capital stock of a corporation and therefore own an interest in its assets. Stockholders as such do not necessarily participate actively in the management of the company. They do not have to be employees of the corporation. A stockholder has certain basic rights in the corporation, including the following: • sell or transfer shares of stock • subscribe for additional issues of capital stock if and when issued (preemptive right) • receive dividends, if declared, in proportion to the number of shares of stock owned • in the event of liquidation, share in the assets in proportion to the number of shares of stock owned • attend and vote at stockholder’s meetings. Note, however, that not all kinds of stock have voting rights. Usually "common stock" has this right. Board of Directors of a Corporation. The board of directors is elected by the stockholders and constitutes the managing body of the corporation. The directors can act only as a group. As individuals, they are without power to transact the business of the company. The board meets at least as often as called for in the bylaws. It selects the administrative officers and thus delegates its management authority to the company officials. The official decisions of the board are recorded in the minutes of its meetings. These minutes are the corporation accountant’s authority for certain entries pertaining to the corporate capital. Quite often, decisions relating to the purchase of insurance need to be authorized by the directors and officially documented in the minutes of the board of directors meeting. Corporation Officers. The bylaws of a corporation generally provide that certain officers are to be elected by the corporation. Corporate officers and their functions might typically be as follows: • The president is usually the chairman of the board of directors and is the chief executive officer. The president generally presides at meetings of the stockholders and directors and makes appointments as needed. • There may be one or more vice presidents. They are responsible for specified operations, such as engineering, production, or sales. • The secretary keeps the official records of the corporation, including minutes of meetings. • The treasurer is the custodian of company funds and supervises their receipt and disbursement. Capital Stock The charter of the corporation gives it the power to issue a specified number of shares of capital stock, which is another way of saying "stock." (The two terms are interchangeable.) The amount of stock originally authorized is determined largely by how much the incorporators want to raise as initial capital. The corporation does not need to issue the entire number of shares authorized at any one time, or ever. But if it does issue all of this stock and then desires to issue more later, it must first receive approval of the state. Authorized capital stock may be sold for money, property, or service. When it is sold and certificates issued, the authorized stock is known as issued capital stock. Capital stock that is authorized, but not issued, is called unissued capital stock. Par or No-Par Value Stock in Corporations. Each share of capital stock may have a par value or it may be of no-par value, according to specifications in the charter. Par value is simply a nominal figure. It has no necessary relationship to the real value of the stock. It is merely the amount at which it is recorded on the books of the company. For example, many companies set par value at $1. Originally issued stock may be sold by the company at par or above par value. If state regulations permit, it may even be sold below par. If no-par stock is issued, it is carried on the books at the amounts for which it is sold. Classes of Capital Stock. The two most usual classes of stock are common and preferred. If a corporation issues only one class of stock, it is called common stock. Practically all common stocks carry the privilege of voting for all stockholders. Since the claims of the common stockholders are subordinate to the claims of other classes of stockholders, relatively greater risk is attached to the ownership of common stock. However, the power to declare dividends rests with the board of directors, who are elected by the common stockholders. Thus, the greater risk may be rewarded with larger dividends. Most closely held corporations issue only one class of stock. Preferred stock usually does not carry the right to vote, but it normally enjoys the right to receive dividends before dividends are paid on the common stock. In the event of liquidation of the corporation, the preferred stockholders will receive the return of their investment before the common stockholders receive anything. Closely Held C Corporations This lecture deals primarily with closely held corporations as contrasted with publicly held corporations. Also known as closed corporations and close corporations, closely held corporations constitute the vast majority of all corporations. They are seldom owned by more than a handful of people, each of whom is engaged actively in the day-to-day management of the business. The stock is not listed on the stock exchanges and rarely changes hands except at death, retirement, or a major realignment within the firm. There is a tendency to view corporations as formal business organizations—rigidly structured, managed, and administered. The fact is that many closely held corporations are not this way at all. Some corporations are little more than sole proprietorships with "incorporated" added to the name. Although a sole proprietor might have become president by incorporating, nothing substantial has changed in the day-to-day operation of the business. He or she is the sole stockholder and therefore continues to make all of the decisions just as before. Other corporations might be partnerships turned corporate. The old partners are now stockholders, but the business goes on much as before despite the fact that one is now president and others are vice presidents. One noticeable difference is that certain major decisions must be recorded and annual meetings of the stockholders must be held. Such annual meetings are also likely to be informal, perhaps taking place at a dinner table over a cup of coffee. Characteristics of Closely Held Corporations The general characteristics of a corporation apply to both closely held and publicly traded corporations. However, the personal structure and the methods of operation of the typical closely held corporation bring about some important differences. Understanding these distinguishing characteristics will help you come to know the closely held corporation’s needs for business life insurance. • Union of Ownership and Management—In closely held corporations, each stockholder usually has a threefold role as a director, an officer, and an employee as well. The owners are the managers. Therefore, death of an owner means death of a key employee of the corporation. • No Ready Market for the Stock—A characteristic of a public corporation is that its shares may be bought and sold on the stock exchanges. In closely held corporations, however, a few employees are the major stockholders. Ordinarily, the only persons interested in buying the shares of a deceased closely held stockholder are the surviving stockholders or possibly a competitor. The stock owned by the deceased stockholder’s family generally is worthless to them unless it is sold or unless they own enough of the stock that they can use their influence to hire themselves as paid employees. In and of itself, stock of a closely held corporation generally provides no income for the family. As will be discussed later, this is a key reason why having a buy-sell agreement is so important for all stockholders of closely held corporations. Here is where your "sale" will be made, and funding the buy-sell is where insurance enters the picture. Limited Liability: Theory Versus Reality—Many creditors will insist that loan notes be signed not only by the appropriate corporate officer of a closely held corporation, but also by the corporate owners personally. If the corporation cannot repay the loan, the owners are personally responsible to repay it. Thus, the legal limit of a shareholder’s liability is meaningless in such cases. Insurance to cover these personal notes is just as important to the stockholder’s family as is insurance on a homeowner’s life to cover the mortgage. Dividends and Unreasonable Compensation—In virtually all closely held C corporations, the owners are also salaried employees of the corporation. In theory and in practice, they can set their own salaries at whatever levels they wish. If given free choice, it would be foolish for owners to pay themselves dividends instead of salaries because salaries are tax deductible by the corporation while dividends are not. Closely held corporations generally pay no dividends. Were it not for a provision of the law dealing with reasonableness of compensation, the owner-employees of a corporation could reduce or even eliminate corporate taxable income simply by paying themselves extremely large (and tax-deductible) salaries. The reasonable compensation provision allows the government, in effect, to force the corporation to treat a portion of the owner’s salary as a dividend. In cases where the IRS audits a corporation’s tax returns and is successful in challenging the reasonableness of compensation, it will limit the corporation’s tax deduction for that owner’s salary to a certain dollar amount. The balance of what had been treated as salary must then be "un-deducted" by the corporation and reported instead as taxable corporate income. In general, the IRS determines reasonableness of compensation by reviewing the entire compensation package (including fringe benefits) of the owner-employees. The IRS compares this total compensation with that paid in comparable companies. S Corporations Someday you will be talking with a prospective client who will tell you that his or her business organization is an S corporation. This section covers much of what you need to know about this form of business organization—its structure, ownership, tax status, the impact of death, and other insurance-related considerations. S corporations get their name from that part of the Internal Revenue Code that gave them birth, namely, Subchapter S of Chapter 1 of the Internal Revenue Code. Although 1982 legislation officially designated them as "S corporations," you might run into their older names of Subchapter S corporations, Sub S corporations, or simply Sub S. The form used by S corporations for reporting their income is Form 1120S. (C corporations use Form 1120.) Similarity to Partnerships Although S corporations have some of the important features of closely held corporations, they are taxed in part like partnerships and in part like corporations. Here’s how they resemble a partnership: • As with partnerships, there is generally no federal income tax levied on S corporations. (Certain levels of capital gain and passive income such as interest are taxable if certain conditions exist.) • As with partnerships, S corporations are pass-through forms of business. The owners of S corporations are taxed on their proportionate share of the earnings of the corporation. It does not matter whether the earnings are actually distributed to the owners or remain with the corporation as undistributed earnings. Either way, the owners must report earnings personally. Expenses and losses are passed through directly to the shareholders. The popularity of S corporations fluctuates with changes in income tax law and the tax status of individuals and their businesses. Corporate tax rates can sometimes exceed individual rates, and individual rates can exceed corporate rates at different income levels. Decisions to incorporate as a C or S corporation will often vary based on the relative income tax brackets of the individual owner(s) and the corporation. At certain income levels, business owners would rather have income taxed to a C corporation, rather than have it passed through to their individual taxes via an S corporation structure. For example, if there are good business tax deductions, such as in the start-up phase of the business, an S-corporation can be a more favorable organization from a tax standpoint during the early loss years. An "S"election allows corporate losses to be deducted on the returns of individual shareholders. When the business becomes more profitable, the S election may be changed to a C corporation to have profits taxed to the corporation rather than the individual owner(s). Additionally, losses of an S corporation may be used to offset income earned outside the business if this is desirable from an income tax perspective. Because all earnings-even undistributed earnings-are reportable by the shareholders, S corporations are not subject to the accumulated earnings tax. (The accumulated earnings tax, covered later in detail, is a tax on certain levels of profit retained by closely held corporations.) There is no such thing as unreasonable compensation in S corporations. As you recall, the concept of unreasonable compensation is the way by which the IRS makes sure that tax-deductible salary is not really a disguised dividend. In S corporations (as in partnerships and sole proprietorships), there is no tax on the corporation itself, since it is a pass-through form of business. This allows the stockowner to take out all corporate income without the normal double taxation on C corporate profits. Similarity to Corporation S corporations resemble closely held corporations in the following ways: • Both S corporations and closely held corporations have continuity of life. They can legally continue as going concerns despite death of a shareholder. • Each shareholder’s liability is limited to the amount of his or her investment. This is true in both closely held corporations and S corporations. • Legally, shares of ownership are readily transferable. In practice, however, since S corporations cannot have more than 100 shareholders, their shares lack marketability as do those in most other closely held corporations. Some states impose corporate taxes on S corporations just as if they were regular corporations. Distinct Characteristics of S Corporations S corporations differ from closely held corporations or partnerships in the following ways: • The legal limit of shareholders in an S corporation is 100. In C corporations the number is unlimited. • Shareholders of S corporations may be any individuals except nonresident aliens. (This prohibition against nonresident aliens exists because nonresident aliens pay no income tax to the U.S. Government.) In addition to individuals, estates, and certain trusts also are eligible to be shareholders. • Amounts contributed by the S corporation to qualified retirement plans are generally deductible. This is true regardless of whether or not the employee is a shareholder. Amounts paid by the corporation for other fringe benefits such as group term life insurance or disability income insurance are deductible by the corporation for coverage on all employees except those employees owning more than 2 percent of the corporation. In addition, such over-2-percent-shareholder employees must report these corporate payments as taxable income. This is not the case with C corporations. Regular corporations are generally referred to as C corporations, taken from the Internal Revenue Code subchapter that establishes them. This terminology is useful, especially to distinguish S corporations from C corporations. • To become an S corporation, all the shareholders of a corporation must vote in favor of it. • • Revoking the status of an S corporation requires consent of one or more shareholders owning 50 percent or more of the voting stock. • The corporation must be domestic. There can be only a single class of stock. • Certain events cause the S status of a corporation to be terminated. • These disqualifying events include having more than 100 shareholders or having an ineligible shareholder. Why Use S Corporations? The most important reason why S corporation status is elected is that the owners can take advantage of corporate expenses and losses to reduce and offset their other personal income at tax time each year. In this respect, S corporations are similar to partnerships: business losses and expenses pass through to the owners personally as offsets against current income. Since it is usually new businesses that anticipate losses, it is therefore new businesses that most frequently elect S status as opposed to regular corporate status. And because such losses are typically "paper losses" brought about primarily by cost recovery (depreciation) of capital assets, it is often new businesses with substantial capital investments that elect S status. According to the IRS, about 40 percent of all S corporations report net losses. To understand why losses are so important for tax purposes, look at an S shareholder’s ownership as a tax-sheltered investment. Two characteristics of many tax shelters are that they produce a real dollar income to the investor, while also providing paper losses for federal income tax purposes. For example, an S shareholder might receive, say, $30,000 in distributed earnings while his or her share of depreciation losses might come to $20,000. The result would be taxable income of only $10,000 instead of $30,000. By way of comparison, losses in a C corporation do not pass through to the stockholders. Even the corporation itself cannot deduct such losses in the current year; it must wait until a year in which it has a taxable gain to offset. Why not partnership? There is one notable limitation relating to the pass through of losses of an S corporation. Each shareholder can deduct losses only to the extent of his or her basis. Basis is the amount invested in the business. The higher the basis, the more a shareholder can deduct. Why Not Partnership? A question to ask at this point is why not just become a partnership? While partners can benefit from a pass-through of losses, partnerships do not have the advantages of continuity of life, limited liability, and ease of ownership transfer that S corporations have. Another appealing feature of S corporation status is that it allows the stockholders to vote to go back into a regular corporate form. Usually, the intent is to do this once the major tax losses and high early expenses are used up. Limited Liability Companies (LLCs) An important innovation in forms of business organizations is the limited liability company (LLC). All states now allow LLCs, and their numbers are mushrooming nationally into the hundreds of thousands. LLCs are very similar to limited liability partnerships (LLPs are partnerships in which all partners are sheltered from liability for partnership activities). A limited liability company combines some basic concepts of partnerships, C corporations, and S corporations. Owners of LLCs are called members. In many respects, a limited liability company is like an S corporation, but has some additional advantages, and fewer disadvantages. Limited liability companies combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. In other words, LLCs have the benefit of being taxed only once on their profits, and the owners of the LLC, or "members," are not personally liable for the LLC’s debts and liabilities. In addition, LLCs are more flexible and require less ongoing paperwork than an S corporation. Here are some of the characteristics that make LLCs so popular. Membership in LLCs Unlike S corporations, which have a limit of 100 owners, limited liability companies have no limit on the number of members. Members may be individuals or entities. Generally, start-up costs will exceed those of a simple partnership or corporation due to the more complex nature of the operating agreement. Unlike S corporations, which prohibit nonresident aliens as owners, limited liability companies have no restrictions on foreign ownership. Unlike S corporations, which allow only one class of ownership, limited liability companies allow different classes of ownership. LLCs are attractive to family businesses that want to keep control in the family. How is this accomplished? Generally, ownership interests cannot be transferred without the consent of other members. Limited liability of LLCs Unlike general partners who have unlimited liability for debts of the partnership, the financial liability of LLC members is limited in the same way that shareholders of C and S corporations are limited. That is, a member’s financial liability for debts of the business is limited to his or her contribution to the LLC. Unlike limited partners, LLC members can be active in the management of the business. A limited liability company is valuable for professionals because it protects the assets of each member against the negligence of the other members. There is no shelter from liability for an individual’s own actions. LLCs are Taxed as Sole Proprietor, Partnership, or Corporation For federal income tax purposes, LLCs may be treated as a sole proprietorship, partnership, or corporation. Tax regulations provide rules to determine how a business entity is classified for tax purposes. If a business has a preponderance of the characteristics of a regular (C) corporation, it will be treated for federal income tax purposes as a corporation. A business with only one owner can elect to be taxed as a sole proprietorship or as a corporation. Businesses with two or more owners can elect a partnership or corporate tax status. The tax filing status will determine other characteristics, benefits and disadvantages of the business entity as described throughout this chapter. Most of the discussion on LLCs in this section assumes the use of the corporate form of organization. LLCs in General LLCs are most useful for new businesses that are just forming, or for partnerships that want to become LLCs. Existing partnerships or S corporations converting to LLC status may do so tax-free. There will be no gain or loss recognized on the transfer of assets and liabilities so long as each partner’s or owner’s percentage of profits, losses and capital remains the same after the conversion. If an existing C corporation elects to become an LLC, it will be a taxable event for federal income tax purposes. The corporate shareholders will be responsible for any taxes due on corporate gains, because they will be taxed as though the C corporation assets had been distributed to them. In most states, dissolution of the LLC is brought about by several events, including death. However, most states allow the remaining members of the LLC to vote to continue the LLC. Depending on the state law and the LLC’s operating agreement, this election to continue may require approval of all members, or only a stipulated percentage of them. Professional Corporations and Professional Associations At times, an individual practitioner or a group of practitioners of the same profession decide to incorporate. In most states, C corporations that provide professional services, in areas such as dentistry, accounting, engineering, actuarial science, performing arts, architecture, law, consulting, or medicine, are required to form a professional corporation. State laws define what constitutes a professional service, but they typically require a license to operate in that state. They are owned, organized, and operated by licensed practitioners of a common profession as an individual or group corporate practice rather than as a sole proprietorship or partnership. Some states use the term "association" rather than "corporation." When you see "John Jones, M.D., P.A.," the P.A. stands for Professional Association and has the same meaning as incorporated. "Ltd." (Limited) is sometimes used as well. State laws establish these terms, so there are variations by state. Some professional corporations are also personal service corporations. The term personal service corporation is a federal income tax categorization used by the Internal Revenue Service to describe corporations in which the principal business activity is performing personal services and where those services are performed mostly by owner-employees. The main difference in these terms, then, is that the term professional corporations refers to state regulation and licensing, whereas the term personal service corporation refers to the federal income tax treatment of professional corporations. Of course, not all professionals choose to incorporate. Some find it more advantageous to function as sole practitioners or as partners, while others elect S corporation status. Characteristics of a Professional Corporation Although state laws are not uniform, there are a few basic ways in which virtually all professional corporations differ from other closely held corporations. Ownership of Professional Corporations. Ownership is limited to licensed practitioners in a given profession. For example, only licensed dentists may be shareholders in a corporation established to practice dentistry. This stipulation applies to initial shareholders and future owners alike. However, when a shareholder dies, the decedent’s estate can legally be the shareholder for a specified duration, while the estate is being settled. The estate cannot vote or participate in management decisions, however. When a shareholder of a professional corporation dies, the surviving owners may purchase the deceased’s stock within a specified period of time—usually a few months. If they choose not to buy the stock within that time and if no other qualified buyer is found, the corporation itself must acquire it—usually within 6 months. This legal requirement makes it critically important for every professional corporation to have a buy-sell agreement specifying how the price will be determined and how funds will be provided. Scope of Operations of a Professional Corporation. The practice of a professional corporation is generally limited to one field of endeavor. For example, if several optometrists incorporate, they could not expand into unrelated products or services. Limited Liability of Professional Corporations. Although no professional is protected against his or her own negligence, a professional corporation can protect a practitioner against liability for the negligence of an associate. Since the primary risk of a practice is malpractice liability, this limitation can be significant. Board Membership in Professional Corporations. Only practitioners may be officers or board members. They do not have to be shareholders. Prospects for Professional Corporations. State laws are not uniform as to which professions may incorporate. Some states restrict the eligible professions to as few as four, while other states allow incorporation or association by practitioners of any profession that requires licensing by the state. Among the professionals who may generally incorporate are the following: • Physicians • Surgeons • Attorneys • Accountants • Dentists • Optometrists • Engineers • Architects • Chiropractors • Osteopaths • Actuaries • Psychiatrists • Podiatrists • Radiologists • Pathologists • Ophthalmologists • Pharmacists • Psychologists • Social Workers • Marriage Counselors • Veterinarians • Chiropodist Since there is a wide variance as to who may form a professional corporation or association, check your own state laws to determine your prospects in this area. Insurance Needs of Professional Corporations Professional corporations and associations offer about the same advantages as closely held commercial corporations, including tax deductibility of insurance-related fringe benefits for the owner-practitioners. The rules for qualified retirement plans for professional corporation are the same as for all other corporations. There are key people to be insured to cover losses that will be incurred as a result of their death or disability. Establishing buy-sell agreements is the only sound and prudent way to handle the orderly transfer of ownership at death of a shareholder-practitioner. Life insurance remains the surest, simplest, and most cost-efficient way to fund the agreement. Definite plans should be established as to what will be done if an owner becomes disabled for an extended period of time. Funding for these plans should include disability income insurance on the owners’ lives. The personal life and disability income insurance of each owner must be considered. Personal Service Corporations As described above under professional corporations, a personal service corporation’s principal business activity is performing personal services. At least 95 percent of the stock must be owned by employees performing the personal services. Corporations in this category are those engaged in accounting, actuarial science, architectural, consulting, engineering, health, law, and performing arts. Many professional corporations are also personal service corporations and are taxed accordingly. IRS takes the position that it is what the company does rather than who the shareholders are or what they call themselves that determines the tax status. There are two key points about taxation of personal service corporations. First, there is a flat tax rate paid on profits at the corporate (entity) level. That is, every dollar of income is taxed at the same 35 percent. Second, at most levels of income, they are taxed higher than C corporations, since the benefit of the graduated corporate income tax rates is not available. Because of this, professional corporations are not as popular as they once were. Corporations try to distribute all profits in the form of wages to the employee-shareholders performing the services. This in effect can eliminate the negative results caused by the flat 35 percent tax.

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